Mechanics of forward and futures markets

Derivatives and Risk Management

Master in Finance
Barcelona GSE-UPF
Professor: Manuel Moreno,
[email protected]

Outline
1. Forward Contracts
2. Futures Contracts
a) Specification of the futures contract
b) Convergence of futures prices to
spot prices
c) Liquidation of positions
d) Operation of margins

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 1. Forward Contracts

A forward contract is an agreement between
two parties to buy or to sell a specified amount
of an asset (underlying asset) for a certain
price (forward price, delivery price) at a
specific date in the future (maturity date).

This contract is traded in OTC markets.

Maturity date and price are fixed today.

Delivery and payment are done at
the maturity date.

This contract has no initial cost.

There is a long and a short position.

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The buyer (long position) MUST buy
the underlying asset in the future day and
to the price previously agreed.

The seller (short position) MUST sell

the underlying asset in the future day and
to the price previously agreed.

Example
• On 11-January, two traders enter in a
forward contract on 10 BBVA stocks.
• The maturity day is 16-March and the
delivery price is 16 €/stock.

• At maturity, there are two alternatives:

BBVA stocks trade at 16.5€.

BBVA stocks trade at 15€.

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1. On 16-March, BBVA stocks trade at 16.5€.

• The buyer pays 16€ x 10 stocks = 160€ and

receives 10 stocks. These stocks are sold in
the market and the buyer receives16.5€ x 10
stocks = 165€. Then, the buyer gets 5€.

• The seller has sold the stocks at 16€ but, in

the market, each stock trades at 16.5€.

Then, the seller loses 0.5€ x 10 stocks = 5€.

2. On 16-March, BBVA stocks trade at 15€.

The buyer pays 16€ x 10 stocks = 160€ and
receives 10 stocks. These stocks are sold
and the buyer receives15€ x 10 stocks =
150€. Then, the buyer loses 10€.

The seller has sold the stocks at 16€ but, in
the market, each stock trades at 15€.
Then, the seller gets 1€ x 10 stocks = 10€.

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Therefore:

The “long position” prefers the
market price of the underlying
asset to increase.

The “short position” prefers the
market price of the underlying
asset to decrease.

Profit from a Long Forward Position

Profit

Price of Underlying
F(0,T) at Maturity, ST

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 Profit from a Short Forward Position

Profit

F(0,T)
Price of Underlying
at Maturity, ST

2. Futures Contracts

We have 2 problems related to forwards:

DEFAULT RISK: one party (the one that
loses money) does not satisfy his obligation
at maturity.
To avoid this, forward contracts are usually
agreed between firms with a certain known
solvency.

A second problem is LIQUIDITY RISK.

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These risks can be avoided by creating the
futures market. This is the organized
Exchange in which futures are traded.

Forwards are agreements between the

parties while, in futures, there exists a market
that is responsible of the trading.

In this way, the counterparty of the futures

buyer is not the futures seller but the futures
markets.

Therefore, both the buyer and the seller have to contact to

an intermediary (or a member of the market), who contacts
to the market:
Buyer of the
Intermediary
futures

Futures
Markets

Seller of
Intermediary
the futures

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 2a) Specification of the futures contract

The market establishes all the terms of the contract:

Size: Number of “underlying” units to deliver.

• Type and quality of the underlying asset.

Time: Maturity date, hours of the day.

When and where the delivery occurs, …

Both parties must accept these conditions.

That is, futures contracts are absolutely

STANDARDIZED

This standardization provides liquidity to the market

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 Clearinghouse

It is the part of the Exchange that acts as an
intermediary between the different parties.

Trades can only be performed through its
members.

Investors trade through brokers.

Brokers trade through Clearinghouse members.

The Clearinghouse eliminates default risk as it

guarantees the party making money will be paid.

Gains and losses on each party’s position are
collected and charged daily.

This
process is named “daily settlement” or
“marking to market”.

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EXAMPLE OF MATURITY DATE: In MEFF, there is a
monthly maturity for futures on the IBEX-35 (the third
Friday in each month) and another maturity every three
months for futures on stocks: March, June, Sept,
December.

In general, with several alternatives (different days to

deliver the underlying asset, different places, etc.), the
party with the SHORT POSITION CHOOSES the
alternative she prefers.

Example of futures contract

Market: Chicago Board of Trade.

Product: wheat, class n. 2, hard type.

Quantity: 5.000 kilograms.

Delivery: last week of July, Sept, Dec, May.

Stored in Chicago-city.

Tick (minimum change in price): 0,25 c./ K.

Trading: Monday-Friday, 9:00 to 17:00.

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 2b) Convergence of futures prices to
spot prices

The spot price is the price of the “underlying”.

When time goes by, the futures price converges

to the spot price.

At maturity, both prices are almost equal.

To check it, we will use arbitrage strategies:

Arbitrage Strategies

At maturity (T), we consider 2 alternatives
depending on the relationship between the
futures price (FT) and the underlying price
(ST):

a) FT > ST

b) FT < ST

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A. If FT > ST, the investor strategy will be
1. To buy the underlying asset, paying ST
2. To take a short position in the futures
contract
3. To deliver the underlying asset,
receiving FT

Then, the profit is equal to - ST + FT > 0

If all the investors perform this strategy, ST

will increase and FT will decrease until
FT ≤ ST

B. If FT < ST, the investor strategy will be

1. The investor takes a long position in the
future and waits until delivery
2. She receives the “underlying”, pays FT
and sells it in the market receiving ST

Then, the profit is equal to ST - FT > 0

If all the investors perform this strategy, ST

will decrease and FT will increase until
FT ≥ ST

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Then, the equation FT = ST eliminates the
arbitrage opportunity.

In practice, FT is very close to ST, although

both may be slightly different.

Idea: The profit from the arbitrage strategy

can be smaller than the commissions to
pay when trading the assets.

Graphical Representation

Futures price
Spot price
Spot price
Futures price

Time Time

Contango Backwardation

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 2c) Liquidation of positions in a
futures contract

In general, in a forward contract, the investor is
interested in the physical delivery of the underlying
asset.

However, in most of the futures contracts, the parties

do not deliver the underlying asset and the contract
is liquidated before maturity.

Liquidation of a position implies to implement the

opposite transaction to the original one.

Example

On 6, May, an investor buys 1 futures contract
on corn that mature at 15, July.

The investor liquidates the position at 20, June,

selling the futures contract maturing at 15, July.

F1: futures prices at 6, May.

F2: futures prices at 20, June.

ST: underlying price at maturity (15, July).

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If the long position arrives at maturity, the
profit / loss at 15, July, is
ST – F1

If the short position arrives at maturity, the
profit / loss at 15, July, is
F2 – ST

As the investor has both positions, her total
profit / loss is
(ST – F1) + (F2 – ST) = F2 – F1

The futures market eliminates this contract and the

investor obtains a profit / loss of F2 – F1

Similarly, an initial short position can be liquidated

before maturity by taking the same number of long
positions, obtaining a profit of
F1 – F2
where

F1: futures price of the initial short position

F2: futures price of the long position taken in a

second stage.

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Futures contracts are usually closed
before maturity as, in most of the cases,
investors are not interested in delivering the
underlying asset.

Investors are usually more interested in

a) hedging a certain risk or

b) making a profit (speculation).

2d) Operation of margins

When a futures contract starts, both parties
(buyer / seller) have to pay a certain initial
deposit.

This deposit (initial margin) is a guarantee that

will be used if one of the parties does not
satisfy her obligation in the contract.

This initial margin is usually expressed in

monetary units.

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Later, daily liquidations are performed. As a result,
the buyer and the seller of the contract receive or
pay depending on the daily profits / losses.

This process is named daily settlement or

“marking to market”.

To compute profits / losses, the (daily) settlement

price is obtained as the average of the quotation
prices for the futures during the last minutes of the
session.

There also exists an amount (maintenance margin)

such that if, at any moment, the accumulated loss
makes the balance lower than the maintenance
margin, the party receives a margin call and must
transfer additional funds (variation margin).

This additional payment leads the balance of the

margin account to the initial margin level.

If the party does not transfer funds, the position is

liquidated.

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 Summary

Initial margin: deposit for each party when the
position is opened.

Marking to market: process to compute the daily

value of the position (balance in the margin
account).

Losses are subtracted from the initial deposit.

If current balance < maintenance margin.

→ “Margin call” → additional payment.

Example

3, June: an investor takes a long position on a futures
on General Motors shares.

Characteristics of this contract:

Maturity: 7, June.

Size: 100 shares.

Futures price: $50 / share.

Initial margin: $500.

Maintenance margin: $200.

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Liquidation prices (in dollars) of the
futures contract for the days 3 to 7, June,
are 48, 47, 46, 45, and 46, respectively.

Day Futures DAILY ACCUM. MARGIN ADDITIONAL

LIQUID. PROFIT / PROFIT / ACCOUNT MARGIN
PRICE LOSS LOSS BALANCE (margin call)

3-06 48 -200 -200 300 -

4-06 47 -100 -300 200 -

5-06 46 -100 -400 100 400

6-06 45 -100 -500 400 -

7-06 46 100 -400 500 -

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When a long position is liquidated by taking a short position,
the profit is F2 – F1, where

F1: Initial price of the futures and

F2: Futures price at the liquidation moment.

What happens at the end of each day?

3, June: Closing the position, we get a profit of

(48 – 50) x 100 = - $200 as F1 = 50, F2 = 48
→ Margin account balance is $300.

4, June: Profit from yesterday: (47 – 48) x 100 = - $100

→ Margin account balance is $200.

5, June: Profit from yesterday: (46 – 47) x 100 = -$100

→ Margin account balance is $100 (<$200)

→ The investor receives a margin call and extra payment of
$400 is needed
→ Margin account balance is $500 ( = initial margin level).

6, June: Profit from yesterday: (45 – 46) x 100 = -$100
→ Margin account balance is $400.

7, June: Profit from yesterday: (46 – 45) x 100 = $100

→ Margin account balance is $500.

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Summarizing:
We have lost (46 – 50) x 100 = $400.
This loss has been distributed on a daily basis.
At the end, we receive $500 from the account and the
operation ends.

If the contract had been a forward, the profit should be

obtained at the end of the contract, 7, June:

• We would pay the agreed price:

$50 / share x 100 stocks = $5,000.

• We receive the underlying asset, that amounts to:

$46 / share x 100 stocks = $4,600.

• Then, we obtain a loss: $5,000 – 4,600 = $400.

Some Terminology

Open interest: total number of contracts
outstanding (equal to number of long
positions, number of short positions).

Settlement price: price just before the

final bell each day. It is used for the daily
marking to market.

Trading volume: number of trades / day.

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 Forwards Versus Futures

• Private contract, OTC • Exchange traded

• Non-standard contract • Standard contract
• One delivery date • Several delivery dates
• Settled at maturity • Settled day by day
• Delivery or final cash • Usually closed before
settlement usually maturity
occurs

Forwards Versus Futures

Characteristics FUTURES FORWARDS

Type of market Organized No Organized

Conditions Standard Customized
Maturity Standard Any
Deposits or margins Set by Clearinghouse No
Daily updating of losses Performed daily by the Done by the participant
and gains Exchange in the markets
Relation between parties Anonymous Direct
Limits on daily changes Set by Clearinghouse Any

When we should contract a futures or a forward?

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